To which financial estimate in the decision tree is the EMV most sensitive?


The Mobile Oil company has recently acquired oil rights to a new potential source of natural oil in Alaska. The current market value of these rights is $90,000. However, if there is natural oil at the site, it is estimated to be worth $800,000; however, the company would have to pay $100,000 in drilling costs to extract the oil. The company believes there is a 0.25 probability that the proposed drilling site actually would hit the natural oil reserve. Alternatively, the company can pay $30,000 to first carry out a seismic survey at the proposed drilling site. Historically, if the seismic survey produces a favorable result, there is a 0.50 chance of hitting oil at the drilling site. However, if the seismic survey produces an unfavorable result, there is only a 0.14285 probability of hitting oil. The probability of an unfavorable seismic survey when no oil is present is 0.80.

a. What is the probability of a favorable seismic survey?

b. What is the probability of an unfavorable seismic survey?

c. Construct a decision tree for this problem.

d. What is the optimal decision strategy suing the EMV criterion?

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